Contestability recap

Lesson objectives Recap how markets can become more contestable Differentiate the level of contestability between markets and what determines it using industry examples Explain using a diagram the implications of contestable market theory on firms in the industry Introduce the economic underpinnings of “competition policy”

Contestable Markets Recap – New entrants ‘Hit and Run’ tactics – enter the industry, take the profit and get out quickly (possible because of the freedom of entry and exit) Cream-skimming – identifying parts of the market that are high in value added and exploiting those markets

Contestable Markets Recap Note that the threat of new entrants may encourage positive OR negative behaviour by incumbents Key characteristics: No (low) barriers to entry or exit No (low) sunk costs Firms’ behaviour influenced by the threat of new entrants to the industry Firms may deliberately limit profits made to discourage new entrants entry - limit pricing Firms may attempt to erect artificial barriers to entry – e.g…

Contestable Markets Over capacity – provides the opportunity to flood the market and drive down price in the event of a threat of entry Aggressive marketing and branding strategies to ‘tighten’ up the market Potential for predatory or destroyer pricing Find ways of reducing costs and increasing efficiency to gain competitive advantage

Barriers to Contestability No market is perfectly contestable – there are always some barriers! Existing firms can engage in predatory behaviour to make entry more costly to new rivals Raising rivals’ costs Vertical integration means that some firms act as component suppliers to other firms in their industry – they have control over the supply-chain (also known as vertical restraint) The use of import tariffs to increase the relative prices of overseas output Reducing rival’s revenues – “bundling” A monopoly can use profits in one market to boost market power in another (cross-subsidisation)

Bundling – Anti-Competitive Behaviour? Product bundling is a marketing ploy of giving away a relatively cheap product with a relatively expensive one to attract customers Bundling can have the effect of tying the consumer to both products This is particularly prevalent in computer manufacturing where the product comes with specific items of software already pre-loaded

Banking Where are the opportunities to skim or hit and run? Use your checklist sheet Banking Where are the opportunities to skim or hit and run? Barriers to entry? Barriers to exit?

Banking Where are the opportunities to skim or hit and run? Barriers to entry? Brand loyalty Marketing Legal Financial Barriers to exit? Opportunities to skim? - Improve Customer service? Move into most profitable sector: high net worth individuals where they can charge fees, lots of money hanging around to earn interest Opportunities to hit and run? - difficult as you can’t sell someone a bank account and then move on to a different industry - barriers to exit Barriers to entry Capital Trust Branch network Brand Legal Barriers to exit Customers expect the bank to continue

Evaluating Contestable Markets There are no perfectly contestable markets What matters is the degree of competition / contestability The idea is that what matters is not so much competition within a market, but rather competition for a market. What also matters is the threat of entry of new suppliers – but this may not be enough to affect the behaviour of existing firms The absence of competition in a market over a long period of time does not necessarily suggest a lack of contestability Structural changes in costs in different industries can change the degree of contestability Contestability may force existing firms away from profit-maximising behaviour (e.g. towards sales-revenue maximisation)

Over to you… Draw Monopolist’s profit maximising equilibrium How might the monopolist react to the threat of hit and run entry by removing the new entrants’ incentive? Revenue Output (Q)

Normal Profit Contrasted with Profit Maximisation Got this far in this lesson Price If the monopolist charges the profit-maximising price, then - if the market is contestable – the firm will be vulnerable to hit and run entry The only way the monopolist can avoid this happening is to set the price equal to average cost, so that there are no supernormal profits to act as an incentive for entry MC ATC P1 P2 No one in the industry has any advantage over anyone else AR MR Q1 Q2 Output (Q)

Implications of contestable market theory The number of firms in an industry is irrelevant in terms of economic efficiency Abnormal profits attract new entrants driving down prices and ensuring economic efficiency All markets (excluding natural monopoly) can be efficient so long as they are contestable Shifts the emphasis of government competition policy away from number of firms towards reducing barriers to entry in an industry Potential competition may be more important for economic efficiency than actual competition

Contestable Markets Examples of markets exhibiting contestability characteristics: Financial services Airlines – especially flights on domestic routes Computer industry – ISPs, software, web development Energy supplies The postal service?

N.B. Exam board likes the topic of contestability Remember the threat of competition can be as effective as actual competition Key is the relationship between sunk costs and the degree of contestability

Contestability 10 minute essay “To what extent is the UK banking market a contestable market” Agree a structure as a group Divide up the work amongst yourselves Write the bullet points of an essay

Government intervention to maintain competition in markets

Why does the Government OR Why does the Government seek to make markets more contestable? Why does the Government intervene to maintain competition?

Competition Policy Efficiency Competition Consumers Toughened since 1997 Competition Policy Promote Competition Protect Consumers Enhance Efficiency Assumption is that competition eliminates x-inefficiency Better resource allocation vs. Economies of scale

Competition Policy At the heart of competition policy is the comparison between Perfect Competition and Monopoly Draw the two LR equilibrium diagrams

PC and “Multi-plant” Monopoly compared Big Assumption! No cost difference between the two market structures Government Remedy = Increase Competition! PC and “Multi-plant” Monopoly compared Part of consumer surplus transferred to Monopoly as profits The Monopolist at constant returns to scale can continue to supply with no change in MC Price PC Consumer Surplus Deadweight loss = cost on society B Pm Thank You! E LRS (=LMCm) Ppc PC firms prepared to supply any quantity at this price C D=AR MR O Qm Quantity Qpc Monopolist supplies Qm at price Pm PC firms supply Qpc at price Ppc

Homework Read and make notes on Anderton Ch 58 P380-382 Be prepared to hand in your notes at next lesson

Define the term “Competition Policy” and explain why it exists Plenary Define the term “Competition Policy” and explain why it exists